New PJM Rules Contribute To 37 Percent Increase In Capacity Auction Clearing Price

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1 RESEARCH North America Power and Utilities Smart Grid New PJM Rules Contribute To 37 Percent Increase In Capacity Auction Clearing Price Power Generators To Gain From High Capacity Payments While Power Prices Increase For Consumers August 31, 2015 Policy Brief Author Erin Carson Chief Policy Strategist Janis Kreilis Analyst Contact (212) Key Takeaways: Power generators will benefit from higher clearing prices in PJM s 2018/2019 capacity market auction while facing higher penalties in case of non-performance Share of natural gas will remain significant through either new generation or uprates to existing generation Demand response, energy efficiency and renewables potentially have a larger role in subsequent auctions and could check price increases Consumer and environmental groups criticize the new capacity performance rule because of higher costs and dirtier generation secured in the auction Higher procurements from fossil fuel-powered plants indicate barriers to entry for renewables and incompatibility with power plant emission regulations Related Research NY REV Utility Models Center On Customer Empowerment FERC Approves Reforms to PJM Capacity Market Entities Mentioned: Exelon Corp Federal Energy Regulatory Commission Natural Resources Defense Council NRG Inc PJM Interconnection LLC This report is for industry information only and we make no investment recommendations whatsoever with respect to any of the companies cited, mentioned, or discussed herein. Please refer to the end of this report for analyst certification(s) and other important disclosures.

2 Insight for Industry PJM s New Capacity Market Rules Contribute to Higher Auction Clearing Prices, Procurement Exceeds Target On August 21, 2015, PJM Interconnection LLC (PJM) released the results of the 2018/2019 Reliability Pricing Model (RPM) Base Residual Auction (BRA), the first capacity auction held under the new Capacity Performance (CP) reforms designed to ensure adequate incentive for resource performance in PJM s capacity market. The auction attracted strong response from capacity resources prepared to meet the new pay-for-performance standards, indicating resource availability to meet future needs using innovative solutions. The 2018/2019 delivery year resource clearing price (RCP) for CP resources, which include generation, demand response (DR) and energy efficiency (EE), was $164.77/megawatt-day (MWd) for all of PJM except ComEd and Eastern MAAC delivery areas where prices exceeded $200/MWd due to transmission constraints. The RCP represents a 37 percent increase over the $120/MWd result from the 2017/2018 auction. Originally scheduled for May, the 2018/2019 BRA was delayed until August 10 to incorporate the new and controversial CP requirement approved by the Federal Energy Regulatory Commission (FERC) in June. The new CP product imposes stringent operational requirements with larger capacity payments for over-performing resources and higher penalties for non performers. PJM has utilized its RPM since 2007 to obtain generation capacity or demand reduction commitments three years ahead--minimum lead-time to build new power plants if necessary--to meet peak load projections. The RPM consists of annual competitive BRAs which set long-term market price signals for new capacity and reliability investments. The new capacity market rules reflect the changing nature of the generation fleet with increasing generation from intermittent renewable and gas-fired units to ensure long-term reliability of electricity supply in the PJM region. The $10.9 billion total cost of the capacity procured represents a $3.4 billion increase over 2014 The $10.9 billion total cost of the capacity procured represents a $3.4 billion increase over Power generators will profit in millions, while consumers will face higher power prices. Utilities that deliver electricity and are not generators may not benefit from an increase in capacity costs on the supply portion of bills. The auction resulted in approximately 3,500 MW of new capacity predominantly gas-fired through new generation or uprates to existing plants, which is a noticeable decline from the 5,900 MW in the previous auction. Generation imports showed a slight increase over last year, when PJM imposed capacity import limits (CILs) due to concerns that transmission constraints could hinder the power delivery of external resources. Given the transition to 100 percent CP in two subsequent auctions, the 2018/2019 auction results indicate a positive trend with the majority of the resources offered as CP, indicating their willingness to meet the new requirements, which includes more responsibilities and stiffer non- EnerKnol, Inc. All rights reserved. 2

3 performance penalties. The CP transition will increase the implied costs of committing to perform as capacity resource due to the investments required to improve generator performance to be available when needed. According to PJM, stronger CP requirements represent an insurance policy for consumers against capacity shortages and price spikes in extreme events, and the auction prices are consistent with the costs of securing capacity. Resources that commit to CP will incur additional costs due to potentially needed investments in fuel-supply, weatherization, and system upgrades to ensure reliability. Power market prices are likely to be less volatile as payments from underperforming resources are directed to overperforming resources. Transitional auctions to integrate the new CP into the 2016/2017 and 2017/2018 Delivery Years for which forward auctions have been completed are scheduled for August 26 and 27 and September 3 and 4, respectively. DR Participation Shows Slight Increase Despite Uncertainty Pending Supreme Court Review of Order 745 Total DR procured represents 11,084.4 MW, an increase of MW from the previous BRA. On the other hand, the total EE procured represents 1,246.5 MW, which is a decrease of 92.4 MW from the previous year. A total DR of 11,675.5 MW was offered into the 2018/2019 BRA representing an increase of 3.4 percent from the 2017/2018 BRA. Approximately 94.9 percent of DR and 95.4 percent of EE resources that were offered into the BRA cleared. According to PJM, the uncleared DR and EE resources were offered at a price above the applicable LDA-specific clearing price. Increased DR participation indicates the possibility for significant DR innovation, so as to facilitate aggregation for combined capacity offers and continued participation as CP. Aggregated offer allowance will facilitate CP participation for resources that otherwise may be unable or unwilling to take part on a stand-alone basis due to lack of reasonable investment to mitigate non-performance risk. Continued DR participation partly depends on the pending Supreme Court ruling on FERC Order 745, which requires RTOs and ISOs to compensate DR in wholesale energy markets at the full locational marginal price. In April, FERC rejected PJM s stop-gap DR proposal aimed to mitigate uncertainty in the event that the Supreme Court upholds the decision to vacate Order 745. PJM s proposed contingency measures for DR participation would have shifted DR from a supply-side resource to the demand-side in its BRAs, causing DR to be considered as a regional system demand reduction, not as an added supply resource as in the current structure. It would have allowed a wide range of wholesale entities, ranging from load-serving entities to electric distribution companies, to submit DR bids. The August BRA was conducted with existing DR rules, keeping DR as a supply-side product pending Order 745 decision. Renewable resources clearing in the auction totaled 14,347 MW nameplate capacity. Continued DR participation partly depends on the pending Supreme Court ruling on FERC Order 745, which requires RTOs and ISOs to compensate DR in wholesale energy markets at the full locational marginal price EnerKnol, Inc. All rights reserved. 3

4 Capacity Performance Resources Represent More Than 80 Percent of Capacity Acquired, Priced at a Premium to Base Capacity The capacity procurement satisfies the new capacity requirements which require PJM to procure at least 80 percent of capacity from CP resources for the 2018/2019 and 2019/2020 Delivery Years. In the auction, the CP clearing price is $15/MWd higher than the base capacity clearing price. The 2018/2019 capacity auction cleared 166,836.9 MW of unforced capacity for a reserve margin of 19.8 percent, accounting for Fixed Resource Requirement (FRR) load and resources. The reserve margin is 4.1 percent higher than the target reserve margin of 15.7 percent. Of the 166,836.9 MW of capacity that cleared in the auction, 154,506 MW were from generation capacity resources, 11,084.4 MW were from DR, and 1,246.5 MW were from EE resources (Table 1). Capacity offers that did not clear in the August auction will be eligible to offer into the incremental auctions for the 2018/2019 Delivery Year. In the 2018/2019 BRA, 138,228.9 MW (89.5 percent) of the total cleared generation capacity cleared as CP; 1,484.2 MW (13.4 percent) of the total cleared DR capacity cleared as CP; and MW (71.2 percent) of total cleared EE capacity cleared as CP. Renewable resources clearing in the auction totaled 14,347 MW, which represents their nameplate capacity as renewables are discounted for capacity due to their intermittent nature. The majority of renewable resources cleared the auction as base capacity but failed to attract the CP premiums secured by conventional power sources. This is one of the factors the might put renewables at a disadvantage to conventional power under the new auction rules. Renewable resources that cleared in the auction include MW of wind (compared to MW cleared the previous BRA) and MW of solar (compared to MW cleared in the previous BRA). The capacity factor MW eligible for capacity requirements for every 100 MW of energy applied to wind resources is 13 percent, implying that the cleared capacity translates to 6,593.8 MW nameplate capability expected to be available in the 2018/2019 Delivery Year. Solar resources have a capacity factor of 38 percent, with the cleared solar capacity representing MW is expected to be available in the 2018/2019 Delivery Year. Table /2019 BRA - Megawatts of Unforced Capacity Procured by Type Renewable resources clearing in the auction totaled 14,347 MW, which represents their nameplate capacity as renewables are discounted for capacity due to their intermittent nature Source: PJM The auction attracted approximately 3,500 MW of new generation, including more than 2,900 MW of new generating units and 500 MW of uprates to EnerKnol, Inc. All rights reserved. 4

5 existing generating units. Of the 11,084 MW of DR procured for , 1,484 MW is CP. EE totaled 1,247 MW, with 887 MW being Capacity Performance. Power Generators to Gain from Higher Capacity Payments, while Consumer Bills Expected to Increase The 2018/2019 capacity auction resulted in a RCP of $164.77/MWd, a 37 percent increase over the $120/MWd result from the 2017/2018 auction. The RCP for CP resources, which include generation, DR and EE, was $164.77/MWd for all of PJM except the ComEd and Eastern MAAC delivery areas. For the two constrained areas, the ComEd Capacity Performance clearing price was $215/MWd; the Eastern MAAC price is $225.42/MWd (Table 2). Capacity costs were set at higher levels for two regions because of supply constraints. ComEd is in northern Illinois while Eastern MAAC is made up of Public Service Electric and Gas Company, Jersey Central Power and Light Company, PECO, Atlantic City Electric, Delmarva Power and Rockland Electric Company. The base capacity clearing price was $149.98/MWd, about $15 less than the Capacity Performance price. The base capacity price in ComEd was $200.21/MWd; in Eastern MAAC, $210.63/MWd; and in the PPL delivery area in Pennsylvania, $75/MWd. Table /2019 BRA Resource Clearing Prices ($/MWd) The base capacity clearing price was $149.98/MWd, about $15 less than the Capacity Performance price Source: PJM The new capacity market transition will increase the implied costs of committing to be a Capacity Resource because of additional investments required to make improvements in generator performance during Performance Assessment Hours, leading to overall higher capacity market prices. Furthermore, low energy market prices attributed to low natural gas prices have reduced net energy market revenues across the PJM system, particularly for coal and oil steam units and nuclear units, which results in higher capacity market offers from these resources. Exelon, NRG Energy Inc., Dynegy Corp, and Calpine Corp. which own generation in areas with higher prices were the biggest winners of the auction. However, Exelon announced that three of its nuclear plants Quad Cities in Illinois, Oyster Creek in New Jersey and Three Mile Island in Pennsylvania did not clear the auction. The company is expected to make a decision on retiring Quad Cities, in order to inform PJM about availability for the 2019/2020 auction. Exelon President and CEO Chris Crane stated that the auction results indicate the beginning of a level playing field and PJM market reforms are in the right direction to recognize nuclear energy s high reliability. EnerKnol, Inc. All rights reserved. 5

6 In the meantime, consumers are expected to pick up the tab. According to Chicago-based Consumer Utilities Board (CUB), a nonprofit charged with representing utility customer interests in Illinois, typical ComEd supply customers would pay roughly $3 to $7 per month more from June 1, 2018 through May 31, 2019, compared to current levels. Alternative supplier customers also will face higher prices, which will vary by company. CUB has opposed the change, saying it would be expensive for consumers and that there was no proof it solved the reliability problem it claimed to address. Environmental groups, such as Natural Resources Defense Council (NRDC), have criticized the results of the new auction by pointing out that renewables, such as wind and solar, earned less than fossil fuel-powered plants. By increasing capacity requirements throughout the PJM area instead of the problematic plants, PJM has raised barriers to the entry of renewables into the market, charges NRDC. Finally, the new rules and the outcome of the auction have raised questions about their compatibility with the Clean Power Plan which aims to reduce carbon pollution from power generation. New Generation Capacity Resources Dominated by New or Uprates to Existing Natural Gas Units The auction results indicate that 84.9 percent of the new generation capacity that offered into the 2018/2019 BRA cleared the auction. Generation capacity resources offered into the auction totaled 4,132.6 MW comprising 3,447.4 MW of new generation units and MW of uprates to existing units. Of this, 3,506.9 MW cleared the auction, including 2,919.3 MW from new generation units, primarily natural gas combined cycle and combustion turbines, and MW from uprates to existing units (Figure 1). The new rules and the outcome of the auction have raised questions about their compatibility with the Clean Power Plan which aims to reduce carbon pollution from power generation Figure /2019 BRA New Generation by Type (MW) Source: PJM External Generation Capacity Resources accounted for 4,687.9 MW, an increase of MW from the previous BRA when CILs were first EnerKnol, Inc. All rights reserved. 6

7 implemented to address transmission constraints that could prevent some external resources from delivering into the PJM region. All external generation capacity that cleared in the auction met the CIL exemption requirements. To qualify for the exception, resources must commit to being pseudo-tied to be treated as internal generation, subject to redispatch and locational pricing, have long-term firm transmission service, and subject to must-offer requirements. Despite the substantial increase in demand side participation since the launch of RPM in 2007/2008, demand side participation and cleared resources for the 2018/2019 Delivery Year dropped below the 2014/2015 level. Demand side participation includes active load management prior to 2007/2008 Delivery Year, Interruptible Load for Reliability and DR offered into each BRA and nominated in FRR Plans, and EE resources starting from the 2012/2013 Delivery Year. EE resources pertain to projects involving equipment or system efficiency improvements that exceed current standards at the time of installation and recognized at the time of commitment. The resulting reduction in energy consumption during the defined EE performance hours must be permanent and continuous and is not reflected in the peak load forecast used for the BRA of the concerned delivery year. The EE resource must be fully implemented throughout the delivery year, without the requirement for notice, dispatch, or operator intervention. Of the 1,306.1 MW of EE offered, 1,246.5 MW of EE resources cleared in the auction. Auction Results Reflect Changes to RPM Design Elements; Higher Penalties for Capacity Performance Failures The new capacity requirements in the 2018/2019 BRA require internal and external generation capacity resources except intermittent sources and Capacity Storage Resources to be offered as CP resources. Intermittent sources include wind, solar, landfill gas, river-generated hydroelectricity and other renewables. Although categorically exempt from the CP must-offer requirement, intermittent and storage resources may offer all or a portion of their capability as CP. A resource may seek exception to the must-offer requirement by demonstrating that it is physically incapable to meet CP resource requirements. The CP provisions require PJM to procure two capacity product types Capacity Performance and Base Capacity. For the and delivery years, PJM will procure at least 80 percent of capacity requirement from CP resources and the remainder from base capacity resources. For the delivery year and beyond, PJM will procure 100 percent capacity requirement in the form of CP. This designation is significant, because CP resources are expected to provide energy and reserves when needed throughout the delivery year, particularly during performance assessment hours resulting from emergencies. In contrast, CP resources are expected to provide energy and reserves when needed throughout the delivery year, whereas base capacity resources are expected to perform only during the summer period EnerKnol, Inc. All rights reserved. 7

8 base capacity resources may not provide the same availability level as CP and are expected to perform only during the summer period. CP resources are also subject to a significant non-performance charge throughout the delivery year, whereas Base Capacity Resources, including Base Capacity DR and EE Resources, are subject to a non-performance charge only during the summer period, at a lower rate compared to CP. In addition, while Base Capacity Generation Resources are expected to be available throughout the Delivery Year similar to CP resources they are subject to non-performance charges only if they fail to perform during summer months. As Base Capacity Resources may not commit to CP standards, constraints are imposed on the quantity procurable in each RPM auction. In addition to the impact of the new CP requirements, PJM stated that the auction results reflect changes to its variable resource requirement curve shape and gross CONE values approved by FERC in November (ER ). Power Outages during 2013/2014 Polar Vortex Main Reason for New Capacity Auction Rules PJM s forced generation capacity outages in the 2013/2014 winter, along with long-term distributed generation trend, prompted PJM to propose capacity market reforms to ensure system reliability. The reforms aim to address weakening resource performance and ongoing changes in the region s resource mix caused by cheap natural gas, new EPA regulations and falling costs of renewable energy. They also demonstrate fundamental transition taking place in power markets, as utilities and regulators adapt to an era of reduced coal consumption and a greater role for distributed generation. The reformed CP market allows DR, EE, energy storage, and intermittent renewable resources to directly participate as a stand-alone CP resource, or aggregate bids for combined capacity within a LDA. The reformed CP market allows DR, EE, energy storage, and intermittent renewable resources to directly participate as a stand-alone CP resource, or aggregate bids for combined capacity within a LDA Under the regulation, PJM aims to procure a target capacity reserve level in a least cost manner while considering reliability-based constraints on the location and type of capacity including: Internal PJM locational constraints established by forming Locational Deliverability Areas (LDAs) Base Capacity constraints on the quantity of base capacity that can be procured in each RPM auction Capacity Import Limits (CILs) on the amount of external generation capacity that can be reliably committed to PJM Each LDA is subject to a distinct target reserve level and a maximum limit on the amount of capacity it can import from resources outside LDA. The Base Capacity DR Constraint applies to Base Capacity DR and EE procurable in each LDA or entire RTO, while the Base Capacity Resource Constraint applies to the sum of Base Capacity DR and EE and Base Capacity Generation Resources; upon reaching the constraints, these less-available resources will clear the auction at a lower clearing price compared to similarly located more-available EnerKnol, Inc. All rights reserved. 8

9 resources. The CIL is established separately for each of the five external source-zones, while a single total CIL is established for the overall RTO; external generation resources may seek exception to the CIL by meeting certain criteria. Given the generating capacity s increasing reliance on natural gas, PJM will offer incentives and cost recovery assurances to encourage additional investments in pipeline capacity to address interruptions in fuel supply and delivery. Low gas prices in the PJM region will likely increase substantial new supplies of gas-fired generation and make up for supply shortages from other sources. However, this would work against the new Clean Power Plan, which aims to decrease carbon dioxide emissions from the U.S. power generation industry. The interplay between these two factors remains to be seen. Low gas prices in the PJM region will likely increase substantial new supplies of gas-fired generation and make up for supply shortages from other sources EnerKnol, Inc. All rights reserved. 9

10 Disclosures Section RESEARCH RISKS Regulatory and Legislative agendas are subject to change. AUTHOR CERTIFICATION By issuing this research report, Erin Carson as author of this research report, certifies that the recommendations and opinions expressed accurately reflect her personal views discussed herein and no part of the author s compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. IMPORTANT DISCLOSURES This report is for industry information only and we make no investment recommendations whatsoever with respect to any of the companies cited, mentioned, or discussed herein. EnerKnol Inc. is not a broker-dealer or registered investment advisor. Information contained herein has been derived from sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be a complete analysis of the company, industry or security involved in this report. This report is not to be construed as an offer to sell or a solicitation of an offer to buy any security or to engage in or refrain from engaging in any transaction. Opinions expressed are subject to change without notice. The information herein is for persons residing in the United States only and is not i ntended for any person in any other jurisdiction. This report has been prepared for the general use of the wholesale clients of EnerKnol Inc. and must not be copied, either in whole or in part, or distributed to any other person. If you are not the intended recipient you must not use or disclose the information in this report in any way. If you received it in error, please tell us immediately by return e -mail to info@enerknol.com and delete the document. We do not guarantee the integrity of any s or attached files and are not responsible for any changes made to them by any other person. In preparing this report, we did not take into account your investment objectives, financial situation or particular needs. Before making an investment decision on the basis of this (or any) report, you need to consider, with or without the assistance of an adviser, whether the advice is appropriate i n light of your particular investment needs, objectives and financial circumstances. We accept no obligation to correct or update the information or opinions in it. No member of EnerKnol Inc. accepts any liability whatsoever for any direct, indirect, consequential or other loss arising from any use of this report and/or further communication in relation to this report. For additional information, p lease visit enerknol.com or contact management team at (212) Copyright EnerKnol Inc. All rights reserved. No part of this report may be redistributed or copied in any form wi thout the prior written consent of Enerknol Inc. EnerKnol, Inc. All rights reserved. 10